By Brian Johnson
Santa Barbara Association of Realtors
The tax-deferred exchange, as defined in Section 1031 of the Internal Revenue Code, offers Americans one of the last great opportunities to build wealth. Since 1921, the 1031 exchange has allowed a property owner to sell their investment property and defer the taxes that would normally be due upon that sale. Notice I said defer. This does not eliminate the taxes due. A 2015 study revealed that 88-percent of exchanged properties were later disposed of through a taxable sale and mostly with more tax collected than if the exchange had never happened. In order to fully qualify an owner must; (a) acquire “like kind” Replacement Property that will be held for investment or used productively in a trade or business, (b) purchase Replacement Property of equal or greater value, (c) reinvest all of the equity into the Replacement Property, and (d) obtain the same or greater debt on the Replacement Property. Debt may be replaced with additional cash, but cash equity cannot be replaced with additional debt. Additionally, the Exchanger may not receive cash or other benefits from the sale proceeds during the exchange.
These exchanges are not a tool of super wealthy. Most 1031 exchange transactions are completed each year by mom and pop style investors. The 1031 exchange is beneficial for not only the property owner but also for local and state governments. The great majority of properties now swapped under the like-kind exchange would not be sold if tax were due. Rather, their owners would continue to sit on the property, and the growth opportunity for putting the investment to better use would be wasted with the government collecting little in extra revenue and missing increases in revenue from higher property tax payments.
Section 1031 can benefit a variety of people in various socio-economic and demographic groups. It is the ultimate equal opportunity tax code provision because it provides an efficient and effective means for individuals to grow their wealth. More importantly, it also assists and incentivizes large economic impact commercial real estate projects in underserved markets that can have a positive effect on low-income, minority, and inner-city neighborhoods.
Brian Johnson is a California licensed real estate agent and the Managing Director of Radius Commercial Real Estate. Brian handles all types of commercial real estate transactions but has a special focus on multifamily investments. He can be reached at 805-879-9631 or firstname.lastname@example.org